Have Treasury buyers lost their heads?
'Would you tell me, please, which way I ought to go from here?' 'That depends a good deal on where you want to get to,' said the Cat. - Lewis Carroll, Alice's Adventures in Wonderland
For Halloween my daughter dressed up as Alice in Wonderland. At this stage I think Treasury investors are living in Wonderland. Let me explain… For the first time since the Civil War, Treasuries have outperformed stocks over a 30-year period. According to Jim Bianco at Bianco Research in Chicago, long-term Treasuries have gained 11.5 percent a year versus the S&P 500 gain of 10.8 percent over the past three decades. Since 1861 stocks have outperformed bonds over every 30-year period. Part of the outperformance of bonds is related to the massive inflows in the retail sector. According to data compiled by Bloomberg and the Washington-based Investment Company Institute, debt mutual funds have attracted $789.4 billion in assets since 2008 versus a net outflow from equity funds of $341 billion. Some point to these inflows as a sure sign of a bubble in the fixed income market. On the other hand, bond supporters are quick to note that you can't have a bubble in an asset class that has a finite life and in which valuations are not that stretched, especially when compared to our current low and persistent inflation rate environment. Personally I don't really care which side is right. At the end of the day long-term investors need to decide if Treasuries offer a compelling long-term investment option. The legendary value investor, Benjamin Graham said it best: 'An investment is something that upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.' It would be very devastating to holders of Treasuries who hold these securities as a vestige of safety to suddenly realise they are not so 'risk free' and offer a very unsatisfactory return. Forgive me if I over-simplify this, but bond valuation typically involves three factors: the real yield, the expected inflation rate, and an inflation risk premium. The longer term real yield average for the ten-year Treasury Inflation Protected Securities ('TIPS') market since 1997 is two percent. Add the 2.1 percent implied inflation rate in the TIPS market plus a 50 basis point inflation risk premium and you get a normal nominal yield on the ten-year Treasury of about 4.6 percent. This compares to the average yield since 1871 (according to Robert Shiller) of 4.65 percent. Taking a cue from an analysis performed by James Montier at GMO, I have constructed the table below which conducts a very simple probability analysis. In the 'My Weights' column I have computed a weighted average of ten-year Treasury bond yields in three different types of inflation scenarios. I have suggested the Treasury Market is 'Normal' 80 percent of the time with a yield of 4.5 percent, inflationary 10 percent of the time with a yield of eight percent, and deflationary 10 percent of the time with a Japanese-like yield of one percent. Doing the simple arithmetic gets a fair value on the ten-year Treasuries of 4.5 percent. Here is where things get interesting and we begin our walk through Wonderland. To see if one is a Mad Hatter buying yields down here, let us look at the implied expectations for the current ten-year Treasury yield of 2.05 percent. If we adjust the probability weights you can find that the market is essentially pricing in a 70 percent chance of a Japan like scenario unfolding in the US, with zero percent chance of hyperinflation and a small 30 percent chance that conditions will normalise. I have written before about how I do not believe the US is like Japan (http://www.royalgazette.com/article/20101129/BUSINESS/311299961). As Alice said: 'It would be so nice if something would make sense for a change.' So before you rush out to the perceived safety of Treasury securities ask yourself, 'where do I want to get to?' If you want adequate real returns to fund your retirement, you may want to consider other options, such as corporate bonds, preferred securities, or high-quality blue-chip stocks.
Nathan Kowalski is the CFO of Anchor Investment Management. Disclaimer: Opinions expressed here should not be construed as investment advice. Please consult your financial advisor on all matters pertaining to your financial goals and planning.